Markets in Action
 

2.1 Price elasticity of demand

When the price of a good rises, the demand will typically fall; in reverse manner when the price falls the demand will rise. However the extent to which demand changes can vary considerably.

When demand is very responsive to price changes it is defined as elastic; when demand is unresponsive it is known as inelastic.

So for example if the price of DVD players falls by 10% and demand rises by 30% (i.e. is very responsive to the price change) this constitutes elastic demand.

If however the price of petrol rises by 10% and demand falls by 5% (is not very responsive to the price change) then demand is inelastic.

More precisely price elasticity of demand is measured

% change in Q_d of a good
% change in its price

Thus in the first example it is measured as - 30%  = -3
                                                                              10%

The measurement is negative because price and demand move in opposite directions.

In the second case elasticity is measured as - 5% = -.5
                                                                               10%

Thus when numerically the measurement is > 1 (in absolute terms) demand is elastic; when the measurement is < 1, then demand is inelastic.
 

Elasticity is determined by a number of factors

When goods are close substitutes for each other demand tends to be very elastic (>1). By contrast demand is inelastic (< 1) for necessities.

Elasticity also depends on the amount of income spent on a good. When a small amount of overall income is spent demand tends to be inelastic

Elasticity also depends on the time period involved.

In the short term (e.g. immediately after an alcohol price increase in a budget) demand tends to be very elastic, though much more inelastic in the long run). In other cases demand is more inelastic (e.g. for meat products) in the short than in the long run.
 
 

2.2. Price elasticity of demand and total consumer expenditure

The basic rule is as follows.
 

If demand is elastic when P increases TR will fall

If demand is inelastic when P rises, TR will increase

If demand is elastic when P falls, TR will increase

If demand is inelastic, when P falls, TR will decrease
 

In terms of the demand curve elastic demand leads to a more horizontal (flat) shape

Inelastic demand leads to a more vertical (steep) curve.

If the demand curve is totally horizontal, this represents totally elastic demand (i.e. infinite).

If the demand curve is totally vertical, this represents totally inelastic demand (i.e. 0)
 
 

2.3 Price elasticity of supply

This measures the responsiveness of supply to a change in demand

% change in Q_s of a good
% change in its price
 

If supply changes by more than price (as a %) then supply is elastic. If it changes by less then it is inelastic
 

Supply differs from demand in that it takes a longer time typically for supply to react to price. These time periods are divided into 4 periods as follows

Immediate market period

Short run

Long run

Very long run

Thus with respect to oil in the immediate market period supply is totally fixed. Therefore any increase in demand will lead to an increase in price.

In the short run existing oil wells could be more intensively worked leading to some increase in supply.

In the long run new oil wells could be opened up leading a further increase in supply.

In the very long run the technology of oil production could change leading to further possible increases.
 
 

2.4 Other elasticities

Income elasticity of demand is also important. It measures the responsiveness of demand to a change in income

% change in Q_d of a good
% change in income

Normally income elasticity is positive. For example an increase in income will lead to increased demand for a product.

However for inferior goods demand actually falls as income rises.

Demand is very income elastic for luxuries (e.g. foreign holidays) and income inelastic for necessities (e.g. food).
 

Cross elasticity of demand measures the responsiveness in demand of one good to a change in price of the other.

% change in Q_d of good X
% change in P of good Y

Cross elasticity is especially important for substitutes and complements.

For substitutes (i.e. goods that can be used in place of each other) cross elasticity is measured as positive.

In other words if the price of Coca Cola was to rise, then the demand for a close substitute (Pepsi Cola) will also rise.

For complements (i.e. goods that are used jointly) cross elasticity is negative.

Thus if the price of petrol was to rise, then the demand for cars will fall (other things remaining equal).
 
 

2.5 Markets and adjustment over time

Speculative elements can have a big effect on markets.

This has led for example to the cobweb theorem

So for example if prices are high this season in the potato market, then if all suppliers were to follow this for the next season there would be a large increase in supply which would cause the price to drop (perhaps by a great deal!)

Likewise if prices are low this season and suppliers adjust accordingly next season by reducing supply then prices could rise considerably. Thus (without speculation) the potato market could be subject to sharp changes in price from season to season.

However in practice these price changes are likely to be modified though speculation.

This can be especially important in financial markets where surprisingly speculation can play an important role in stabilising prices (e.g. arbitrage).
 

2.6 Fixing prices

Governments can attempt to fix prices either above or below the market equilibrium.
For example with the CAP, the EU tried to guarantee prices for farmers above free market rates.

This had many damaging consequences.

Consumers paid higher prices (than in free market).

Food surpluses accumulated which had to be disposed of expensively (through subsidies) in non-EU markets.

Farmers had an incentive to produce more worsening the situation.

Cheaper imports to community had to be blocked (through levies).
 

Prices can be also be set at an artificially low level.

For example tickets for a big match are issued at a price where demand greatly exceeds supply.

This lead to a need to ration out the available supply which usually entails a queuing system.

A black market - where some of the goods - comes back on an unofficial market at a higher price inevitably breaks out where a shortages exist.

Thus before a big match touts will attempt to sell tickets well above the official rate.